The problem, Tim, is that if banks are TBTF then, by definition, they will not be allowed to fail. Banks, knowing this, have an incentive to take risks they would otherwise not--in fact, in a competitive market, they will be forced to take such risks--because for them there is little downside.

For a long time it was thought in the US that the solution was to have lots of small banks, so none would be TBTF. Recent events have shown that this strategy doesn't work. So, what to do?

The government could break up all the banks, so that none would be TBTF. There is no chance of this happening. Apart from the political and legal barriers, it is not clear that such small banks can really be competitive these days. As a result, banks will grow again.

The government could announce that it will never again bail out banks; in effect, say that no bank is TBTF. This would not be credible, certainly not to the big banks, which know better. Thus, the problem would remain.

So, Greenspan is right. This is a problem that cannot go away.

But, Tim, you have stumbled onto the solution. Stricter regulation of banks, especially banks that are TBTF. Such banks cannot be allowed to get into a position where they might fail. Put differently, the incentives for excessive risk taking need to be offset by stricter regulation. This, in essence, was the solution to the S&L crisis of the previous generation. In that case, the bad incentives induced by deposit insurance, which like TBTF caused institutions to take big risks but which could not credibly be withdrawn, were offset by stricter regulation.

I don't know what evidence you have that smaller banks can't compete. There are many "smaller" banks that have not had the catastrophes befall them that the behemouth institutions have. The political will, as I read it, is these banks WILL be broken up.

Not only will all small "community" banks be eliminated and consolidated into the monster TBTF banks but the managers, staff and stakeholders will all be rounded up and interned in Government "reeducation" Centers until there minds are "cleansed" of all "Free Market" dogma. Orwell was right and "BIG BROTHER" has won!

daler,

You raise a good point.

Small banks have proved very resilient over the years, repeatedly confounding predictions of imminent death. To some extent, this reflects laws (like single-branch laws in some states) that protect them, but some of them must be on to something good. And, it is difficult to see why large banks should have a competitive edge. They have more opportunities to diversify, for example (though this certainly didn't help them in the recent mess), but smaller banks can use financial engineering to do much the same thing.

But, they now account for only a small and dwindling proportion of banking system assets. The trend toward ever larger banks has been clear for some time now.

Your reading of the political will is different from mine. Sure, there are lots of calls to break up the banks, but I would be surprised if this was actually done to any extent. In fact, it looks to me like the banking system is going to emerge from the crisis significantly more concentrated than before. Ironically, this is partly because of TBTF: for better or worse, the biggest banks are being supported by the government, and the smaller banks are being absorbed.

To some extent, this reflects laws (like single-branch laws in some states) that protect them, but some of them must be on to something good.

Actually, I think you are underestimating the role of political power to the continued existence of small community banks.

The US has historically had a distrust of large banks (e.g., Andrew Jackson and the Bank of the United States, a general distrust of "East Coast financial interests"). Community bankers were able to capitalize on this distrust and get bank branching laws passed in most states. Bank branching laws resulted in a legion of community bankers who, given their numbers (i.e., votes), wealth (i.e., campaign donations), and community connections (i.e., more votes and donations), yielded tremendous political clout and were not shy about (mis-)using the regulatory process to help their banks. Even though bank branching and interstate banking laws have been repealed,* community bankers still get a lot of favors from state and federal regulators and politicians.

*-The repeal of bank branching and interstate banking laws can partially be explained by a desire by community bankers to increase the value of their banks. In the 1970s and 1980s, community bankers realized they could get a premium for selling their bank to out-of-town banks. So, the community banker lobby modified its position on bank branching and interstate banking.

I certainly agree with that, MnZ.